What A Mess!
By Sucheta Dalal
Technology was supposed to have increased efficiency and
transparency. But a roaring bull market, growth-hungry broking firms
and complacency among regulators is creating enough stress and the
system is coming apart.
MONEY LIFE : Inagural Issue
http://www.moneylife.in/mlm/covermain_aa.asp
This wealth hazard comes with no statutory warning. Automated and
transparent systems are the veins and arteries of an efficiently
functioning stock market. But a blind faith in automation and a rush
towards efficiency brings peculiar problems and could end up as a
trap for investors.
Last December, an unknown Gujarati woman called Roopalben Panchal
and her family was discovered to have thousands of demat accounts,
created to take advantage of retail application quotas in Initial
Public Offerings. Under investigation, the figure of fake demat
accounts started growing. It has already reached a mind-boggling
14807. There were some 47,000 fake demat accounts in the IDFC issue,
over 10,000 fake accounts in the Yes Bank issue and at least 20
other IPOs are still to be investigated. Roopalben and others got
allotments as retail investors and flipped the shares in pre-listing
trades done in the grey market.
National Stock Depositories Ltd (NSDL) and Central Depository
Services Ltd. (CDSL), the shining success stories of modern Indian
stock market came under a cloud. SEBI started asking questions and
the NSDL reacted by challenging the regulator -- an action of
unprecedented gravity.
Around that time, National Stock Exchange (NSE), another showpiece
institution also stumbled. It goofed in calculating the Nifty, when
the market opened for official trading, after a short special
session to discover the price of the post-demerger Reliance
Industries. Confusion reigned for a full 40 minutes on January 18
before the regulator stepped in and restored order. With thousands
of crores of trading positions riding on Nifty futures and options,
market players had to guess the value of Nifty, based on Sensex
values and trade without a reference price.
All over the country, aggressive broking firms are expanding and
acquiring new clients but with minimal safeguards for investors.
There are a string of serious complaints against them. Large brokers
are making obscene amounts of money but fraud by brand name brokers
is not rare.
Is the market under too much of stress because of the T+2 rolling
settlement and could a bigger disaster strike us anytime? Are we
witnessing the development of fault lines in the system? Are Self
Regulatory Organisations (SRO) being too complacent? Have we
developed a blind faith in technology? And are regulators putting in
place appropriate course corrections? Here is a brief snapshot of
the stress points of the system that would affect you as a common
investor and some tips on what you should be doing.
Over the past decade Indian capital market has gone from strength to
strength. The NSE has created history by running a spanking new,
professionally run automated exchange that has armed Indian
intermediaries and investors with execution capability and
transparency at par with international standards.
Separately, we have even outdone Wall Street - the Mecca of capital
markets, in putting together a gigantic dematerialised system of
stock holding that has removed cumbersome paperwork and related
frauds and delays. Proud of its success with stocks, NSDL was
looking forward to take its skills in running a large database to
other areas such as the tax information network. That seems
worrisome now.
Shocking failure of Demat System
You would think that expensive, sophisticated, automated systems
would increase efficiency, transparency and create clear audit
trails that would deter fraud. In fact, an automated system should
have detected multiple applications at two levels: the depository
and the depository participant (DP). Why didn't this happen? Why
weren't multiple demat accounts, large pre-listing trades and
multiple applications not identified? The simple shocking answer is
that depository systems are not equipped to detect multiple
addresses and duplication, although international algorithms for
such checks are easily available.
Depositories may have been taking a rather convenient view of their
job to regulate and inspect DPs. Meanwhile DPs say that their own
software comes from the depositories and they have no responsibility
for 'systemic' flaws. NSDL argues that it is technically not an SRO
under SEBI rules and therefore has no responsibility to monitor the
DPs. Secondly, it didn't know what happened inside its computers but
provided regular information to SEBI and it was the regulator's job
to scan the data for irregularities.
While this may have technical validity, depositories have always had
the standing and respect of an SRO. It is strange that depository
officials totally failed to notice tens of thousands of accounts
engaged in pre-listing share transfers to a handful of entities who
were apparently, willingly forgoing the big profits that were to be
made on listing. NSDL and CDSL were guilty of not looking hard
enough; but banks were actively colluding with IPO scamsters by
financing them and depositing hundreds of refund cheques of diverse
applicants into single accounts. They even lent their address to
these shady applicants. But don't expect the Reserve Bank to
administer strong deterrent punishment. The errant banks were fined
just a few lakhs of rupees.
Faulty software and poor regulation are not the only issues. There
are plenty of other problems with the depository system. Demat
transactions are mandatory in the secondary market but the DP
business suffers from thin margins and there is little interest in
expanding the service outside major metros and large cities. DPs are
expensive for small investors and to switch DPs you have to pay
steep exit charges. SEBI has recently ordered the scrapping of exit
charges.
Banks make little money on their DP services and have always viewed
it as a facility they offer to their clients as part of a
comprehensive service, despite low returns, since the risks are also
supposed to be lower. The demat scam has changed that view and
increased the implied costs. It is now perceived to be a higher risk
business, requiring larger investment in software and
supervision. "This isn't what we had bargained for," a bank chairman
says. What does this mean for investors?
The higher risk and costs will act as a further disincentive to
expanding the DP network and this will affect investors even more.
With poor coverage of DPs in smaller towns and cities, the market
found a solution by asking investors to issue a Power of Attorney
(POA), giving brokers and DPs access to their accounts, or allowing
brokers to hold blank DP slips on their behalf. This is a huge
hidden risk for investors. The regulators have turned a blind eye to
this practice. The irony is that investors find DP charges high, DPs
make very little money, but the NSDL itself makes healthy profits
and companies, who are enjoying huge savings and happen to be the
biggest beneficiaries of paperless trading, are bearing too little
of the costs.
Broking Account Be careful of what you sign away
A monster bull market and large profits enjoyed by broking houses
have led to a frenetic growth in broking services. But the business
is riddled with dubious practices and investors must be careful of
what they are filling in the 'Know Your Client' form. This is a
bulky document full of legal jargon, which most investors avoid
reading because they are assured that it is a SEBI-approved
document. Slipped into the pages is a POA, whereby the investor
allows the brokerage firm and its traders to issue instructions to
their depository accounts for purchase and delivery of shares, or
permitting brokers to withhold funds and square off trading
positions as they deem fit. Every broker has a different POA format.
But they have something in common: they are all loaded against the
investor.
An electronic share is transferred at the click of a button and a
POA that transfers the right to operate your depository account to a
broker is as good as allowing him to access your bank account.
Most people would be shocked at the thought of depositors allowing
their bankers the right to their savings bank accounts, but while
executing stock transaction, they easily allow access to their demat
accounts as well as bank accounts. A vast number of investors have
signed POAs in favour of brokers without realising the consequences.
It can be severe. Consider this.
A Chennai-based investor called S.Radhakrishnan, opened a brokerage
account with India Bulls in 2001 to invest his life's savings in the
form of ESOPs and was doing fine. In 2004 he discovered that instead
of 4000 Infosys shares worth over Rs one crore in his account, he
had a balance of just Rs 300. He alleges that the Chennai branch of
this brokerage firm may have traded on his behalf and now refuses to
provide any answers to the investor. India Bulls has accused the
investor of losing money due to reckless speculation. So far, India
Bulls has not contacted him and tries to push the investor into an
arbitration proceeding, which is bound to be to his disadvantage.
SEBI and NSE have not come up with solutions either, while the
investor continues to run from pillar to post for help.
A Mumbai based couple whose Rs one lakh has vanished was getting no
answers. Pune based Vaibhav Dhoka is running around to recover Rs 12
lakhs after the franchisee of a leading brokerage house ran away
with his money. Again, the NSE pleads inability to do anything on
the pretext of insignificant lapses by the investor. The problem is
that investors are lulled into complacency by the assurances of
brokerage firms, especially in a bull market.
For instance, all large brokers provide on-line access to investors
to view their transactions. Technically, investors can always check
if shares are transferred or credited in their account in line with
their instructions. This works well unless the trader that was
handling the account messes up and causes a major loss. Suddenly
investors find their accounts becoming inaccessible due
to "technical lapses."
The lesson here is simple. Understand the dangers of a Power of
Attorney giving a broker unlimited access to your account and read
what you sign even if the broker says it is in "standard, SEBI
approved format." Some brokerage firms include an additional clause
in the POA, which says that the client can never issue instructions
directly for operating his/her own demat account. This is
outrageous. Investors who sign such POAs are literally giving up
even the right to proper defense later.
If you do not remember what you have signed, ask the broker to show
you the account opening form. The POA is usually a part it. If your
broker refuses to show you the form or makes excuses, you have
reasons to worry. In such cases, start building up documentation by
putting your requests for information in writing, or send them by
email with a copy to yourself.
One investor says that his broker refused to give him a copy of the
margin funding agreement he had signed. If the agreement was fair
and above board, why would he do so? This is a warning bell.
Frequent delays in crediting money or shares, is another warning
signal. Or, if the electronic access to your account is suddenly
jammed or inoperative and not rectified quickly, start worrying.
POA is needed because the DP network has not spread far and wide.
POA is a pre-requisite to opening an internet trading account
because brokers have no option but to seek a POA. The T+2 settlement
system leaves them vulnerable if the investor delays delivery
instructions or payments even by a day. Internet trading is
relatively hassle free, hence trading volumes are growing at 25%
plus. Since, most of this growth has occurred during the powerful
bull run of 2005, there are negligible complaints about abuse or
irregularity. But the situation can change dramatically in a
downturn or even a deep correction.
SEBI is aware of the problem of T+2. Nearly a year ago, a senior
SEBI executive openly conceded that the T+2 rolling settlement
system (trade settled two days after the transaction) was "pure
fiction" and it only appeared to function smoothly because brokers
completed the pay-in on behalf of investors and collected the money
later. But SEBI is doing little to curb the practices that T+2 has
spawned or change the T+2 system itself.
Even when there is no POA, the broker-client agreement itself is one-
sided and has clauses that allow brokers to withhold investors'
shares or money or dispense with written notices and communication.
The problem gets more complex in cases of margin funding. Interest
rates are changed without notice and leveraged purchases are not
transferred to client accounts but held in custody by the brokerage
firm, allowing the broker to use them as a hedge for other trades in
special pool accounts. Shares in pool accounts are often used by the
firm or its employees to deliver against their own day trades that
were not covered at the end of the day, and are replaced later. This
creates scope for a massive fraud when the market suffers a long
correction.
Broker pool accounts were always open to abuse on account of
proprietary trades. Curiously, it is the Bombay Stock Exchange that
worried about such an eventuality and ensured that its own
depository, CDSL, transfers shares directly into broker accounts.
Grievance Redressal: The dice is loaded against you
Since the system is loaded against the investors, how about the
redressal process? There too the dice is loaded against you.
Investor complaints are pushed into an arbitration process that
usually goes against investors who have signed a POA giving
unconditional powers to the broker to operate their trade and bank
account. Often the arbitration process itself is a sham and
anecdotal evidence shows that it can be fixed. This is why, brokers
are too keen to take you to arbitration. The exchanges support this,
thereby unwittingly acting against investors.
Capital market reforms have stalled. There are many edges in the
system as the companion piece by financial expert R Balakrishnan
points out. He also draws our attention to the need for strong
deterrent punishment, which is sorely missing in India. As he points
out, recently China punished a financial fraudster with three years
imprisonment and a hefty financial penalty. Will our regulators ever
do this? We tend to see "white collar crime" as a minor
misdemeanour, thereby encouraging more of it. It is profitable to
break rules and very little downside to getting caught. If SEBI's
punishments were prison terms instead of mild admonishments
like "thou shall not trade in XYZ stock for 3 months" etc., it would
hurt. What will hurt is for business to be suspended or stiff
deterrent penalties that are difficult to cough up.
Here, we are still waiting to get at fraudsters who have now
graduated to try their skills overseas, get registered as FIIs and
come back to this market. There is neither any willingness nor the
ability to punish. The market participants, who are party to this
fraud, get away scot-free with no serious dent to their business
profits. If the regulators were to shut down the business of a party
to the fraud, then things would be different. But, is the
willingness there?
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